Why We All Overreacted To Netflix

International growth is the key

Have you chosen sides yet in the Great Netflix (NASDAQ:NFLX) Debate of 2011? Do you hail CEO Reed Hastings as a far-seeing prophet of online video? Or are you appalled at the madness that led one of the web’s biggest successes to declare that the customer is not always right?

Or are you, like me, shaking your head at the whole stupid debate? The simple truth is that Netflix is pinning its future on streaming media, and doing what it has to do to get there. In the process, it’s botching the transition from DVD-by-mail to pure streaming in a way that will cause it headaches for some time.

Both views have some merit, but both are overreacting. So how do investors respond? Trading strategies in Netflix used to be so simple. You either thought it would be crushed under the wheels of a traditional giant like Blockbuster, or you believed it would prove
naysayers wrong. And in that halcyon past, the longer a bull stayed long in Netflix, the more that bull won.

When all the emotion of the present moment passes, there will be several factors suggesting the company is making the hard choices necessary for its survival, and also several clear things that it screwed up. Here are a few of each:

Netflix is Being Dumb

1. A search too far. When Hastings made his murky and vilified defense of the move to separate DVDs by mail and streaming video, someone asked in the comments whether he’d need to search twice for the same movie, Hastings responded “ouch” – as in, yes, you’re right. To me, that means “we didn’t think this through right” (unlikely) or “we know and just don’t care” (likely).

2. The branding fail. Qwikster, the new name for Netflix’s DVD business, is not only easily confused with Quickster (a collapsible Lacrosse net) and Qwixtar (an Amway business), it’s slang for a guy who can get women in bed quickly. That one’s going down in the annals of bad branding.

Netflix Is Being Smart

1. Nobody outside the U.S. is complaining. This is the thing the critics don’t want to say. If millions of U.S. subscribers fall from Qwikster, that’s great news for the neighborhood video store. But it’s not bad news for Netflix, if angering tens of millions of U.S. subscribers is offset by the addition of a hundred million in Latin America, Europe and Asia. In that case, Qwikster will be an unsightly footnote in the company’s history.

2. The power of scale. Start the countdown until Qwikster is sold off. There’s simply no more growth in it, and without new subscribers Netflix has no leverage in pricing with the big studios. But by getting subscribers in other countries before rivals do, Netflix can scale up its subscriber base into a juggernaut that would make even the most clueless studio executive sit down at the bargaining table. Qwikster may be Netflix’s childhood, but the company is lurching into adulthood and not looking back.

What does all this add up to for investors? Netflix has always had a gift for seeing, several years ahead of anyone else, where the video-rental industry is heading. Until now, it’s managed to pursue that vision by giving consumers what they want. Now, it’s pursuing its vision by denying consumers (U.S. consumers, at least) what they want.

That means Netflix is going to be rather volatile for a while: a risky investment in the short term. It’s likely to fall further as U.S. cancellations pull down revenue and licensing fees push up costs. But once streaming subscriptions start to accelerate internationally, it will surprise the bears and rebound sharply.

No longer is investing in Netflix simply a matter of going long and watching it prove the naysayers wrong. Like everything else in the stock market these days, investing in Netflix is a matter of shrewd timing.